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Using Annuities to Protect Inheritance

If you’re at the point where your portfolio is large enough that your annual spending can be satisfied using a withdrawal rate that’s likely to be sustainable, you don’t need to annuitize any of your portfolio.

But should you do it anyway?

What about buying a single premium immediate fixed annuity large enough to completely fund your living expenses? That would allow you to treat the remainder of your portfolio as an “accumulation portfolio” rather than a “distribution portfolio.” The benefits being that:

When you don’t need to annuitize, the question of whether or not to do it anyway is basically a “break even point” calculation. If you end up living long enough, the return provided by an annuity will make it a great investment, even if you didn’t need it as a risk management tool.

A Silly Example to Make a Point

If you knew with 100% certainty that you were going to live to be 150, an annuity would be a super idea, regardless of whether or not you needed to buy one. The guaranteed payout provided by the annuity would be far higher than the payout that could be safely provided by drawing down a portfolio of stocks, bonds, and cash over that time frame.

The end result: Annuitizing would dramatically increase the amount that you leave to your heirs. (In fact, it could even be wise to annuitize your entire portfolio. The portion of the annuity’s payout that you don’t need to fund living expenses could be used to start building a new “inheritance portfolio.”)

Annuities and Inheritances in Real Life

Of course, in real life you don’t know how long you’re going to live. So–as with much of investing, and retirement planning in particular–it’s somewhat of a guessing game. My analysis would look something like this:

  1. What inflation-adjusted payout can you get from a single premium immediate fixed annuity?
  2. If you used that payout as the withdrawal rate for a portfolio, when would you expect the portfolio to run out?
  3. Do you expect to live longer than that?

If so, an annuity makes sense even if you don’t need one. And the more certain you are, or the longer past that date you expect to live, the more sense it makes to annuitize.

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Comments

  1. As always, an interesting argument.

    But let me understand….are you saying that the ONLY time it makes sense is if you know you are going to live a long time?

    You could, at age 99 buy a life with 20 year certain and in effect guarantee the payments.

    When I do the calculations, it still doesn’t work.

    Insurance companies, philanthropic as they are, still like making money.

  2. I’m saying that the longer you expect to live, and the more certain you are about that, the more sense it makes to purchase a single premium immediate fixed annuity (even if you don’t need to buy one in order to get your withdrawal rate to a sustainable level).

  3. There is a cool planning technique that can be used in a small percentages of cases where you use the SPIA payment to purchase life insurance inside an ILIT, this way your heirs are made whole and you use the excess dollars to do what you talked about.

    It only works if you have an older healthy person since the you get better rates from the insurance company on the Life Insurance, but SPIAs don’t usually have underwriting so you get to create an arbitrage.

    Thoughts?

  4. There is one other consideration- the stability of the insurance company.

    If the company goes broke- say due to speculating with their premiums or because most people are living 50 years longer than their actuarial tables were predicting then the annuity wouldn’t work very well.

    -Rick Francis

  5. It seems to me you are glossing over some uncertainties and not giving enough weight to goals. If you want to leave an inheritance you need to be careful with an annuity. Purchase an annuity for $500,000, walk out of the office and get hit by a truck, and your heirs just lost $500,000. On the other hand if the goal is to be sure you never run out of money (#1 fear of seniors), then an annuity is the way to go.
    If a portfolio is invested in risky assets anything can happen. Mid-2007 many investors felt their portfolios were large enough to produce a comfortable, sustainable withdrawal rate. After seeing the value of homes implode and their investment portfolios shrink drastically they felt they may never retire. A lot of them wished they had annuitized – just not with AIG.

  6. Affordable annuities don’t leave anything for the heirs, unless you count a spouse as the heir.

    A very excellent reason to buy an annuity is that many folks lose their mental acuity as they age. If alzheimer’s doesn’t take you before age 70, then you will probably have difficulty by the time you reach 85. Yes, there are a few exceptional individuals, but, seriously, have you checked how well your relatives did at that age?

  7. The point I’m trying to make is that regardless of goals, the longer you expect to live, the more sense an annuity makes. If you end up living well beyond your life expectancy, having bought an annuity will probably significantly increase the amount you leave to your heirs.

    Yes, it’s hard to say how long a given person will live. But regardless of how you plan on funding your retirement, you have to make some estimate of life expectancy. So if, say, you don’t smoke, exercise regularly, and your relatives all seem to stick around into their 90s, why not account for that?

  8. I think you are making some underlying assumptions I’m not getting or maybe its a matter of semantics.
    An annuity is a game between us and the insurance co. At first cut if I live past my life expectancy I win and we say the insurance co. loses. The insurance co. doesn’t really lose because their actuaries have accounted for a certain percentage living a long time but that’s of no consequence.
    In terms of inheritance, if I retire at 65 and take my entire nest egg and buy an annuity and die at the age of 110 my heirs have zero inheritance. Thus, the annuity doesn’t help the heirs.

  9. “if I retire at 65 and take my entire nest egg and buy an annuity and die at the age of 110 my heirs have zero inheritance. Thus, the annuity doesn’t help the heirs.”

    That’s only true if at every step of the way, you either spend every dime the annuity kicks off or reinvest it in another annuity.

    Presumably, if you have a large enough portfolio that you could get by safely without an annuity (i.e., with a “safe withdrawal rate”) the annuity is going to be providing a payout larger than that required to cover your expenses.

    The “extra” payout could then be invested to create a portfolio for your heirs. If you do end up living well beyond the life expectancy for somebody your age, the remaining portfolio is probably going to be larger than what would have been left over had you not annuitized at all.

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